In a taxpayer-friendly move, the IRS fine-tuned its rules proposed in 2014, issuing final regulations that will help those holding after-tax money in their retirement plans to move it into Roth IRAs.

The usual additions to traditional retirement accounts, such as 401k plans, are made with pre-tax money, allowing more to grow with a tax deferral until it is withdrawn.  However, many individuals contribute after-tax money to these traditional retirement accounts in order to allow it to grow without having to pay tax until it is withdrawn.  This may be an attractive option if you have an employer plan that does not include a Roth option, or you are reaching the maximum contribution limits.  The administrators for these accounts keep track of the pre-tax and after-tax contributions, as well as the growth.

Prior to October of 2014, the only funds that could get rolled over into a Roth IRA were funds from another Roth account.  The IRS issued Notice 2014-54 in October of 2014, indicating that after-tax funds held in a regular retirement account could be rolled into a Roth IRA.

The new rules from the IRS allow the rollover of the after-tax money directly into a Roth IRA, without having to allocate the after-tax money among all of the rollovers as a proportion of the total in the retirement plan, or only being able to roll a Roth plan into a Roth IRA. In other words, you used to have to take a small portion of the after-tax contributions, and separate them among the different accounts into which the 401k was moved.  Now, all of the after-tax money can go straight into a Roth IRA without having to be divvied up among all of the accounts, making it a record-keeping nightmare and diluting the potential tax-free income benefits.

As with any Roth plan, the advantage is that the money initially deposited has already been taxed, but the earnings can growth free of income tax instead of just a deferral of income tax.  A Roth IRA makes sense because, for most people, their income tax bracket when they retire will be lower than their current bracket.

Approximately 40% of employer retirement plans currently offer after-tax contributions.  Just less than 7% of 401k participants make after-tax contributions, when possible.  Thus, there is a good potential for

There are, however, some restrictions with transfers:

  • The disbursements have to be after an employee leaves the employer providing the retirement plan;
  • The rules only apply to distributions with after-tax assets;
  • The rules also apply to disbursements from 403(b) (public school) or 457 (government) plans;
  • There is no impact on distributions of pre-tax funds placed in a traditional employer 401(k) (they must still be rolled over into a pre-tax type of plan like a traditional IRA);
  • A rollover cannot be just the after-tax funds, all of the account must be rolled over, but they do not all have to go to the same destination;
  • The designation of where the after-tax funds go must be made before they are transferred to the new accounts; and
  • The rules effectively took place in October 2014 with the release of the Notice, but the final regulations were effective as of January 1, 2016.

The Notice provides four examples of how this new rule works:

Example 1. Employee C participates in a qualified plan that does not contain a designated Roth account. Employee C’s $250,000 account balance consists of $200,000 of pretax amounts and $50,000 of after-tax amounts. Employee C separates from service and is entitled to, and requests, a distribution of $100,000. Under §72(e)(8), the pretax amount with respect to the distribution is $80,000 ($100,000 x $200,000/$250,000). Employee C specifies that $70,000 is to be directly rolled over to the qualified plan maintained by his new employer and that $30,000 is to be paid to Employee C. Because the pretax amount exceeds the amount directly rolled over, the amount directly rolled over to the new plan consists entirely of pretax amounts. The amount paid to Employee C (prior to application of withholding) consists of $10,000 in pretax amounts and $20,000 in after-tax amounts. Prior to the 60th day after the distribution, Employee C chooses to roll over $12,000 to an IRA. Because the amount rolled over in the 60-day rollover exceeds the remaining pretax amounts, the amount rolled over to the IRA consists of $10,000 of pretax amounts and $2,000 of after-tax amounts.

Example 2. The facts are the same as in Example 1, except that Employee C chooses to transfer $82,000 in direct rollovers — $50,000 to the new qualified plan and $32,000 to an IRA. The remaining $18,000 is paid to Employee C. The new qualified plan separately accounts for after-tax contributions. Because the amount rolled over exceeds the pretax amount, the direct rollovers consist of $80,000 in pretax amounts and $2,000 in after-tax amounts. Employee C is permitted to allocate the pretax amounts between the new qualified plan and the IRA prior to the time the direct rollovers are made.

Example 3. The facts are the same as in Example 2, except that the new qualified plan does not separately account for after-tax contributions. In this case, it is impermissible for the $2,000 (which represents the after-tax portion of the distribution) to be rolled over to the new qualified plan. Thus, the entire $50,000 rolled over to the plan must consist of pretax amounts. The $32,000 rolled over to the IRA consists of $30,000 of pretax amounts and $2,000 of after-tax amounts.

Example 4. The facts are the same as in Example 1, except that Employee C chooses to make a direct rollover of $80,000 to a traditional IRA and $20,000 to a Roth IRA. Employee C is permitted to allocate the $80,000 that consists entirely of pretax amounts to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after-tax amounts.

The new rule does provide savers with more flexibility and better options for their after-tax contributions.  The new rules appear to offer another path to fund Roth IRAs, but the rules limit that opportunity.  However, as with any rollover from a qualified retirement plan, the money must be redeposited with a plan within 60 days of its disbursement to the employee, or through a trustee-to-trustee direct transfer.

As with any other retirement asset, proper estate planning is imperative, whether through beneficiary designations or through a testamentary document, such as a will or trust.

If you have any questions about the new rules, please contact me.

IRS Issues New Rules on Retirement Accounts Rollovers Holding After-Tax Money – and the Taxpayer Wins!
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